FIN 3504 Ch. 10 & 11

BCOOL pays a current dividend of $0.75 per share. The annual growth rate in dividends is expected to be 5% and BCOOL's shareholders require a return of 12.5%. The value of the stock is closest to:

$10.50. Price = (0.75 (1.05)) ÷ (0.125-0.05) = 10.50

Cisco Tech is a growth company that has been paying a dividend of $1.00 per share for the last ten years and has recently paid the same $1 for the current year. Cisco has just created "new tech" that should revolutionize artificial intelligence and therefore has decided to pay higher dividends two years from today. That dividend will be $3.00, followed by a $6.00 dividend the next year, and a $9.00 dividend the following year. It is expected that the following dividend payments will increase by 9% annually. What is the value of Cisco if the required rate of return equals 14%?

$128.73

Compute the free cash flow to equity for a firm with the following conditions (each account is reported on a per share basis): Net Income = $9.25 Depreciation = $1.52 Proceeds from a Bond Issue = $3.00 Total Debt Repayments = $0.45 Change in NWC = -$1.00

$14.32. Rationale FCFE = 9.25 + 1.52 + 3.00 - 0.45 + 1.00 = 14.32 FCFE: +Net Income + Depreciation and Amortization (Add back non-cash expenses) - Capital Expenditures (Cash that is reinvested back into the company) - Changes in Net Working Capital (Working Capital = Current Assets - Current Liabilities) +New Bond Issues or Bank Loans - Debt Repayments = Free Cash Flow to Equity

Crazy Fans Inc pays a current dividend of $1.36 with a growth rate of 2.9%. Crazy Fans shareholders require an 11.1% rate of return. The value of the stock using the dividend discount model is closest to:

$17.07 D0(1+g)/(k-g) (1.36 x 1.029)/(0.111 - 0.029) = 17.066

LEP Tech is expected to pay its first dividend in exactly one year of $1.25 per share. The annual growth rate in dividends is expected to be 6% and LEP's shareholders require a return of 12%. The value of the stock is closest to:

$20.83 Value = (1.25) ÷ (0.12-0.06) =20.83

Jackson Inc. has EPS of $5.625 with a retention ratio of 60%. The annual growth rate in dividends is expected to be 6% and Jackson's shareholders require a return of 11%. The stock price is closest to:

$47.70 V = (D0 x (1+g))/(k-g)_Dividend today = $5.625 x (1 - 0.60) = $2.25 Price= 2.25x(1.06)/(0.11 - 0.06 ) = 47.70

The preferred stock for CRYSTAL pays an annual dividend of $8.42 while the firm's preferred shareholders require an 13.5% return. The value of this firm is closest to:

$62.37. V = D/k Value = 8.42÷0.135 = 62.37

Edgar Corp (EC) is a growth company that has never paid a dividend. The EC board of directors has decided to pay its first dividend one year from today. The first dividend will be $2.00 per share. Because of the growth expectations for the company, it is expected that the following two dividend payments will increase by 40% each year. Beyond that, the EC dividend is expected to grow at 6% annually. What is the value of EC if the required rate of return equals 11%?

$67.71 Step 1: determine cash flows until there is constant growth: D0 = 0_D1 = 2.00 D2 =2.00x1.4=2.80 D3 =2.80x1.4=3.92 Step 2: determine stock price at time = 3 based on constant growth model Price3 = (3.92 x 1.06) / (0.11 - 0.06) = 83.10 Step 3: calculate the NPV of the cash flows:_CF0 = 0, CF1 = 2.00, CF2 = 2.80, CF3 = 87.02 (3.92 + 83.10) i = 11%, solve for NPV = 67.71

Use the information below to answer this question Which of the following is the quick ratio for ABC Corporation (for this question, assume that the "other" current assets are additional inventory)?

0.47 Quick ratio = (cash+marketable securities+accounts receivable)/current liabilities (380+100+130)/1,300=0.469

Use the information below to answer this question. The debt to equity ratio is closest to:

1.21 Total debt/total equity=3,600/2980=1.21

CJD Enterprise's EPS increased from $2.00 last year to $4.00 this year with a 20% increase in sales. If CJD's degree of operating leverage is 3.0, then what is CJD's degree of financial leverage?

1.67. EPS increased by 100%. 100% ÷ (20% x 3.0) = 1.67

ACE has EPS of $10.00 per share and has a retention ratio of 80%. Its dividend is expected to grow at a rate of 9%. If ACE stock is trading at $54.50, then the shareholder's required return is closest to:

13%. R = [(D0 x (1 + g))/P] + g_Dividend today = $10.00 x (1 - 0.80) = $2.00 Return = 2.00x1.09/54.50 + 0.09 = 0.13

FLASH Delivery has EPS of $6.00 per share and has a payout ratio of 40%. Its dividend is expected to grow at a rate of 5.25%. If FLASH stock is trading at $22.86, then the shareholder's required return is closest to:

16.3% r = (D1/P)+g P = current price of stock D1 = D0(1+g) D0 = EPS x payout ratio required ratio = (2.4 x 1.0525)/22.86 + 0.0525 = 16.3%

Acme Industries manufactures mouse traps in its production facility. It sells its mouse traps for $15 each. Acme's fixed costs are $540,000. The variable cost for each mouse trap is $1.50. If Acme sells 70,000 mouse traps, what is its degree of operational leverage?

2.3. DOL = Q(P-V)÷(Q(P-V)-F) = 70(15-1.5)÷(70(15-1.5)-540) = 2.333

Patch Software is expected to pay its first dividend in exactly one year of $0.25 per share. The growth rate in dividends is expected to be 4.5% and Patch's shareholders require 13.8%. The stock value is closest to:

2.69 V = D1/(k-g) V = 0.25/(0.138-0.045)=2.688

Prestige has revenue of $50 million with 20% variable costs. It has $20 million of bonds financed at 6% and has fixed costs of $30 million. What is Prestige's degree of total leverage?

4.5. DOL = ($50m - (0.2 x $50m)) ÷ [($50m - (0.2 x $50m)) - $30m] = 4 EBIT = $50m - $10m VC - $30m FC = $10m Interest = $20 million x 6% = $1.2 million DFL = EBIT ÷ (EBIT - I) = $10 million ÷ ($10 million - $1.2 million) = 1.136 DTL = DOL x DFL = 4 x 1.136 = 4.545

Arrow Inc. earned $1m in EBIT this year. If it earns $1.2m in EBIT next year and it has 2.0 degree of operating leverage, what is the change in EPS?

40%. EPS increase equals 40%: 20% increase in EBIT x 2.0 DOL

Acme Industries manufactures mouse traps in its production facility. It sells mouse traps for $15 each. Acme's fixed costs are $540,000. The variable cost for each mouse trap is $1.50. How many units must Acme sell to break even?

40,000. $540,000 ÷ ($15.00 - $1.50) = 40,000

Walt Co.'s EBIT increases by 20%. If Walt Co. has a degree of financial leverage (DFL) of 2.5, what is the expected change in earnings per share (EPS)?

50%. Financial leverage magnifies EPS. Therefore, if EBIT increases by 20%, then EPS will increase by 50% (20% x 2.5).

A firm in the water bottling industry pays a current dividend of $2.19. Its earnings per share is $8.36 and an analysis of the financial statements shows a return on equity of 9.32%. The sustainable growth rate is closest to:

6.88%. Growth Rate = Retention Ratio x ROE. Retention Ratio = (EPS - Dividend)/EPS. Growth Rate = 8.36 - 2.19/8.36 x 0.0932 = 0.0687

Hydra, Inc. pays a current dividend of $3.40 and shareholders require a 12.5% return. The dividend will grow at a high rate of 30% and then gradually decline to 4% over a six-year period. The value of Hydra shares using the H Model is closest to:

72.80 Div0 = The firm's current dividend ag = The firm's long-term average growth rate k = The required return on equity H = The half-life of the transition time from high growth to low growth hg = The firm's short-term high growth rate V = 41.60 + 31.20 = 72.80

Acme's sales increase by 20%. Acme has a degree of operating leverage (DOL) of 3.0 and degree of financial leverage of 1.5. What is the impact of the increase in sales on EPS?

90%. Operating leverage magnifies EBIT and financial leverage magnifies EPS. Therefore, if sales increase by 20%, then EPS will increase by 90% (20% x 3.0 x 1.5).

According to technical analysis, which of the following statements correctly describes a resistance level?

A price that a security will not rise above. A resistance level represents a ceiling price above which a stock is not expected to trade. When a stock is trading near its resistance level, the expectation is that the stock price has peaked and will likely fall.

Which statement regarding financial leverage is most accurate? A) The variation in ROE and EPS is identical to the variation in EBIT if the firm is unleveraged. B) The variation in ROE and EPS is always greater than the variation in EBIT if the firm is leveraged. C) Financial risk is the additional variation in ROE and EPS arising from the use of debt. D) All of the above

All of the above All of the statements are correct.

In Porter's 5 competitive forces used in industry analysis which of the following is NOT a barrier to entry affecting the threat of new entrants?

Availability of substitute products. Threat of substitute products is a separate category to be analyzed among Porter's 5 competitive forces.

Which of the following amplifies EPS? A) Degree of operational leverage. B) Degree of financial leverage. C) Both of the above. D) Neither of the above.

Both of the above. Both DOL and DFL will amplify EPS. DOL amplifies EBIT, which then amplifies EPS. DFL does not amplify EBIT, but amplifies EPS.

A firm with a higher concentration of fixed costs than long-term debt is more likely to be exposed to which of the following risks?

Business risk. Business risk refers to the variability in earnings caused by the industry in which the company operates. Variability in income from operations can be caused by volatility in sales and higher than average fixed costs. Financial risk refers to the variability of returns to stockholders based on the introduction of long-term debt to the capital structure. Default risk is the risk that the company won't be able to pay their debt, and systematic risk is market risk (nondiversifiable).

After examining a tech firm's cash flows, its executive leadership, and its likelihood of becoming a takeover target, a research analyst estimates the intrinsic value for this firm to be $64.50. The current market price on the NASDAQ exchange is $61.10. The analyst is most likely to recommend:

Buying the shares Since the shares have an intrinsic value that exceeds their current market value, the shares are considered to be undervalued. A buy recommendation is the most likely choice as the analyst believes the price will rise to its intrinsic value. Increasing allocation to the entire tech sector is probably an overreaction to this news.

Which of the following is a fiscal policy tool used by Congress that influences the money supply and interest rates?

Debt Management Options b and c are examples of monetary policy, which is controlled by the Federal Reserve. Fiscal policy includes debt management, deficit spending, and taxation. Monetary policy includes excess reserves, the reserve requirement, discount rate, and open market operations. Prime lending rate (choice a) is not part of monetary or fiscal policy

Relative valuation models least likely include: A) Price-to-equity multiple. B) Price-to-book multiple. C) Dividend discount model D) Price-to-sales multiple

Dividend discount model. The dividend discount model is an absolute valuation model, while the others are relative valuation models.

Which is most accurate regarding a firm's common stock dividend policy?

Dividend payments are discretionary and can fluctuate over time. Firms are not legally obligated to make dividend payments, which means they are paid whenever the board of directors believes the firm has enough cash flow to warrant a payment. Dividend payments are discretionary and change all the time. There is no maturity date on an equity issue, and dividends are one of the few accounts that cannot be identified as belonging to assets, liabilities, equity, revenues, or expenses.

According to Porter's 5 competitive forces used in industry analysis, rivalry among companies in the same industry tends to increase under which of the following conditions?

Firms in capital intensive industries characterized by high fixed costs produce high outputs when demand is low. Rivalry among companies in the same industry tends to increase when firms in capital intensive industries that are characterized by high fixed costs tend to produce high outputs even when demand is low. This creates downward pressure on prices, which leads to increased competition. These industries are generally less profitable than low-investment industries.

A firm has operating leverage if it uses which of the following?

Fixed costs. Operating leverage comes from low variable costs. Once fixed costs are covered, increases in sales drop to the bottom line

Which firm has high operating leverage? One with:

High fixed costs and low variable cost. Operating leverage occurs with high fixed costs and low variable costs. Once breakeven has occurred, the majority of sales increases will also increase net income if the firm has low variable costs.

Which of the following statements regarding technical and fundamental analysis is true?

In fundamental analysis, future cash flows are projected by analyzing a firm's financial statements. Options a and c describe fundamental, not technical, analysis. Option d describes technical analysis.

During a period of recession/contraction, which of the following would be true?

Inflation would decrease. During a recession/contraction, there is a decline in demand. GDP is decreasing, inflation is decreasing, and unemployment is increasing. Since demand is decreasing, the supply of goods and services will also be decreasing. To stimulate economic growth, the money supply will likely increase, causing interest rates to decline.

Free cash flow to equity in the current year will most likely increase when a firm:

Issues bonds. Rationale FCFE will fall after large capital expenditures, at least during the current year, when there are increases in net working capital, and if profitability declines. A bond issue will increase FCFE. FCFE: +Net Income + Depreciation and Amortization (Add back non-cash expenses) - Capital Expenditures (Cash that is reinvested back into the company) - Changes in Net Working Capital (Working Capital = Current Assets - Current Liabilities) +New Bond Issues or Bank Loans - Debt Repayments = Free Cash Flow to Equity

Which of the following best describes the usefulness of the Dow theory in technical analysis?

It determines the end of a bull or bear market. According to the Dow Theory once a primary trend is established asset prices tend to move in that direction. The primary trend will be supported by the same directional movement in both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). The primary trend will continue until the trend is reversed, as evidenced by both the DJIA and the DJTA.

Examples of monetary policy would most likely exclude:

Lending at the prime rate of interest. The Federal Reserve Board operates in the open market, can change both the discount rate and excess reserve, but has no direct control over the prime lending rate.

Which of the following stages of the industry life cycle is characterized by increased competition and deceleration of profitability?

Mature growth. In the mature growth stage output is catching up with demand and the industry is no longer accelerating. The recent period of high growth and profitability have attracted competitors, causing margins to stabilize and profitability to decelerate.

Given a current ratio of 1.25, which of the following transactions will increase the current ratio? A) Sell marketable securities to raise cash. B) Prepay part of long-term debt. C) Pay accounts payable from cash D) Delay payment of accounts payable

Pay accounts payable from cash. The current ratio is equal to current assets divided by current liabilities and indicates a company's ability to cover current liabilities. Cash and marketable securities are considered current assets, so a sale of marketable securities for cash would not increase current assets or the current ratio. Prepaying part of long-term debt would decrease the current ratio. Delaying payment of accounts payable will not change current cash or current liabilities. The payment of accounts payable with cash will decrease both balances (current assets and current liabilities), but because the old current ratio exceeds 1.0, the impact will be an increase in the new current ratio. If current assets = 125,000 and current liabilities = 100,000, the current ratio is 1.25. Payment of 25,000 in current liabilities reduces cash to 100,000 and liabilities to 75,000.The new current ratio equals 100,000/75,000 = 1.33. Though cash and payables decrease by the same amount, the new ratio goes up because it is greater than 1.0. Given a current ratio of less than 1, and the same set of circumstances, the new current ratio would be reduced.

PE Ratio

Price per share/EPS

PEG Ratio

Price-Earnings Ratio/Earnings Growth Rate (%)

Total Asset Turnover

Sales/Total Assets

ZAGG investments owns 285,000 shares of CRC, a defensive stock. After examining the stock's cash flows, its executive leadership, and its likelihood of becoming a takeover target, a research analyst estimates the intrinsic value for this firm to be $35.00. The current market price on the NASDAQ exchange is $59.23. The analyst is most likely to recommend:

Selling the shares that are already owned. Since the shares have a market value that significantly exceeds its intrinsic value, the shares are considered to be overvalued and should be sold.

Price to Book Ratio

Share price/book value per share Book value per share = shareholder's equity/shares outstanding

According to technical analysis, which of the following determines market values?

Supply and demand. Technical analysis focuses primarily on the supply and demand in the market, while largely ignoring the fundamental data because technical analysts believe that fundamental information has already been priced into the assets.

Which of the following statements is correct? A) A company that is a going concern cannot be valued using discounted cash flows. B) A company that is not a going concern can generally be valued using discounted cash flows. C) Relative measures of valuation are generally superior to cash flow models. D) The PE ratio is an earnings valuation model.

The PE ratio is an earnings valuation model. Choice a is incorrect as a going concern can be valued using discounted cash flows. Choice b is incorrect as a firm that is not a going concern is usually valued with a method other than discounted cash flows. Choice c is incorrect as the models are used in conjunction with one another. Choice d is correct.

Which of the following will cause free cash flow to equity to increase?

The federal government decreases the tax rate on companies to attract more business to the U.S. FCFE will decrease when it calls bonds and when accounts receivable increase. It will increase when tax rates decrease.

Which of the following is not correct regarding the constant growth dividend discount model?

The model requires that the required return be greater than or equal to the growth rate of the dividend. The model is based on the dividend one period from the valuation period. The model requires that the required return be greater than (not equal to) the growth rate of the dividend. The model can be rearranged to determine the payout ratio. The model is highly sensitive to small differences in the required rate of return or the dividend growth rate.

A firm's price-to-earnings ratio will increase when:

The payout ratio increases From the equation below, it should be obvious that as the numerator increases, so does the PE ratio. The other three answer choices will result in a drop in PE. PE ratio = (D1/E)/(k-g) = payout ratio/(k-g)